garp munis 2013

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The Interest Rate Risk of Municipal Bonds:Challenges and Opportunities

November 18, 2013

2

Topics

Why taxes depress prices of discount munisWhen rates rise, performance suffers undulyBut ‘hold value’ can exceed market price

How strategic selling can enhance after-tax returnHow to determine savings?What is the right time to sell?

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What Will Happen When Rates Rise?

1991 1996 2001 2006 20110.00

1.00

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6.00

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8.00

Bloomberg GO 20yr AAABloomberg GO 10yr AAA

Yiel

d (%

)

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When Rates Rise Prices Will Fall More Than ExpectedBond Buyer, March 18, 2013

Single-APar Bonds

Rates Rise 100bps

Standard Approach Kalotay Approach Δ

Price Yield Price Yield Price Yield (bps)

2-yr 0.90% 98.05 1.90 96.82 2.54 -1.23 64

5-yr 1.65% 95.35 2.65 92.84 3.21 -2.51 56

10-yr 3.00% 91.82 4.00 88.94 4.38 -2.88 38

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Investors Punish Low Coupon Bonds

… buyers demanded an additional 40 basis points for 4% coupon bonds, industry analysts estimated, … [and] … they demandedan additional 80 basis points for 3% coupons [relative to 5% bonds].

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Discount Bonds Get Hit Harder

Lower coupon bonds were hit the hardest in the recent selloff as prices declined much faster than premium bonds …

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Tax Treatment of Tax-exempt Bonds Held to Maturity – Simple Version

* Marginal tax rate implied by EMMA prices is ‘very high’** 0.25 x the number of remaining years to maturity (e.g. 2.50 for a 10-year bond)

Purchase Price Treatment Tax Rate*

At a premium Premium amortized to zero N/A

At a de minimis** discount

Taxed as capital gain 20%

At a non-de minimis discount

Taxed as ordinary income 40%

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Robust OAS Technology Provides the Foundation for Rigorous Analysis

Calibrate Tree

Value Security

Yield Curve and Volatility

Security Specification

Option-adjusted Spread (OAS)

Price

Handbook of Municipal Finance (2008)

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OAS Framework Extended to Munis

Capital gains and losses are taxableInvestors assumed to be in the highest tax bracketKey concepts: after-tax fair price and after-tax OASFair price defined as value of after-tax cashflows, including tax payable at maturity (determined iteratively)After-tax valuation tools are essential for managing interest rate risk and to maximize after-tax performance

Examples below generated by MuniOAS™ and MuniSignal™(patent pending)

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Assumptions for Following Exhibits

Tax Rates

Income 40%Short-term capital gains/losses 40%Long-term capital gains/losses 20%

Issuer Par Optionless Yield Curve

Mty (yrs) 1 2 5 10 20 30Rate (%) 1.0 1.5 2.0 3.0 4.0 4.5

Interest Rate Volatility

20%

Transaction Cost

0.50% par

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Taxes Depress Prices of Discounts 10-Year Bullets

2.40 2.50 2.60 2.70 2.80 2.90 3.00 3.1090

92

94

96

98

100

102

Pre-Tax Market Price

Coupon (%)

Valu

e (%

Par

)

10-Yr Rate 3%

-5 5 15 25 35 4591

92

93

94

95

96

97

98

99

100

101

Pre-TaxMarket Price

Yield Curve Shift (bps)

Valu

e (%

Par

)

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Interest Rate Sensitivity of 10-Year 3% Bond

Current price 100

13

Ignoring Taxes Duration Underestimated10-Year Bullets

2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.48

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10

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13

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After-taxPre-tax

Coupon (%)

Dura

tion

(yrs

) 10-Yr Rate 3%

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After-Tax Duration of 30NC-10 Bonds

3.5 3.7 3.9 4.1 4.3 4.5 4.7 4.9 5.1 5.3 5.512

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14

15

16

17

18

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Coupon (%)

Dura

tion

(yrs

)

30-Yr Rate 4.5%IR Volatility 20%

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Option-Adjusted Spread Measures Credit Risk

Expressed relative to a risk-free benchmark curveWhat is good benchmark curve for munis?Identifies mispriced bonds High OAS signals that bond is cheapUsed in quantifying interest rate riskCalculate prices given yield curves, keeping OAS constant

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Recent AAA 5% NC-10 Curve

0 5 10 15 20 25 300.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Maturity (yrs)

YTC

(%)

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Optionless Par CurvesDerived from 5% NC-10 Curve

0 5 10 15 20 25 300.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

10% Vol 15% Vol 20% Vol

Maturity (yrs)

YTM

(%)

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Ignoring Taxes OAS Overestimated

88 90 92 94 96 98 1000

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40

60

80

100

120

140

1603% 10-Year Bullet

After-taxPre-tax

Price (% par)

OAS

(bps

)

10-Yr Rate 3%

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Tax Management Opportunities

Familiar transaction: selling losers*Known as tax-loss harvestingShort-term loss @ 40% can be very valuableSelling winners (bonds whose value has surged) can also be beneficial at timesRead paper, if interested

*For bonds purchased at a premium, loss is based on accreted basis

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Sale Decision is a Two-Step Process

1. Is it profitable?Compare after-tax proceeds from sale to ‘hold value’Hold value not directly observable

Depends on holder’s basisObtained by OAS-based valuation

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Market Price and ‘Hold Value’ Can Diverge 10-Year Bullets

2.40 2.50 2.60 2.70 2.80 2.90 3.00 3.1090

92

94

96

98

100

102

Coupon (%)

Valu

e (%

Par

)

10-Yr Rate 3%

─ Hold Value Given Above-Par Purchase Price─ Market Price

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Selling LosersBond Purchased at a Premium, Sold Below Par

2.50% Bond – 10 Years to MaturityPurchase Price (2 years ago) 111.85Holder’s Basis 110.00Sale Price 93.23

Tax Savings 3.35After-tax Proceeds from Sale 96.58Hold Value 95.57

Net Value of Transaction 1.01

All values in percent of par

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Sale Decision is a Two-Step Process

1. Is it profitable?Compare after-tax proceeds from sale to ‘hold value’Hold value not directly observable

Depends on holder’s basisObtained by OAS-based valuation

2. Do it now or wait?Compare value of ‘tax option’ relative to savings, i.e. on the ‘tax efficiency’ of the sale

Value of tax option depends on transaction cost and interest rate volatility (even if bond is optionless)

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Benefit from Selling Increases at Higher RatesBond Purchased at Premium, Sold Above Par

-75 -50 -25 0 25 50 75 100-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Yield Curve Shift (bps)

Net

Val

ue o

f Sel

ling

(% p

ar) Current bid

price 117.20

5% bond, 10 years to maturity Purchased 2 years ago at 125.78Current tax basis 122.00

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Interest Rate Volatility Increases Value of Tax OptionGreater Potential for Tax-Loss Harvesting

0 5 10 15 201.0

1.1

1.2

1.3

1.4

1.5

Interest Rate Volatility (%)

Tax

Opt

ion

Valu

e (%

par

)

5% bond, 10 years to maturity Purchased 2 years ago at 125.78Current bid price 117.20

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Tax Efficiency Signals When to Sell

Net value of sale should capture most of the tax option valueDecision depends on risk tolerance; recommended minimum 90%

𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦=𝐴𝑓𝑡𝑒𝑟𝑡𝑎𝑥 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠−𝐻𝑜𝑙𝑑𝑉𝑎𝑙𝑢𝑒

𝑇𝑎𝑥𝑂𝑝𝑡𝑖𝑜𝑛𝑉𝑎𝑙𝑢𝑒

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Short-Term Loss Aids Tax Efficiency

119 120 121 122 123 124-20

0

20

40

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Purchase Price (% par)

Effic

ienc

y (%

)

5% bond, 10 years remaining Purchased 6 months ago at prices shownCurrent bid price 117.20

10-Yr Rate 3%Transaction Cost 0.5%

IR Volatility 20%

Wait

Sell

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Unique Challenges of Managing Munis

Interest is tax-exemptBut gains and losses are subject to complex tax treatment that affects market price and hold valuePerformance of funds is reported pre-taxBut investors are liable for taxes due to salesActive managers should be able to outperform passive investors on an after-tax basisBut standard systems lack critical after-tax capabilities

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References"Taxes on Tax-Exempt Bonds,“ A. Ang, V. Bhansali, Y. Xing, Journal of Finance, Vol. 65, No. 2 (2010)"Optimal Bond Trading with Personal Taxes," Constantinides, G. M. and J. E. Ingersoll, 1984, Journal of Financial Economics, 13(No.3), 299-335. “What Makes the Municipal Yield Curve Rise”, A. Kalotay, M. Dorigan, Journal of Fixed Income (Winter 2008)“The Tax Option in Municipal Bonds,” A. Kalotay, D. Howard, Journal of Portfolio Management, (Spring 2014, forthcoming)“The Interest Rate Sensitivity of Tax-Exempt Bonds under Tax-neutral Valuation,” Journal of Investment Management (forthcoming)“Optimum Tax Management of Municipal Bonds” (working paper)